October 1, 2008

Why You Might Want a Lower Valuation for your Startup

The most obvious point of negotiation in any venture financing is the valuation of the company. The first-order logic is pretty simple: Founders want the highest possible valuation and investors want the lowest. Pretty straightforward. Founders want to go high because it minimizes dilution. Investors want to go low because they get a higher ownership percentage.

For those who aren’t familiar with this math, it works pretty simply. Investors are going to put money into a company. More accurately, they are going to buy shares of stock from the company at a certain price. The higher the price of the company, the fewer shares the investors get for a given number of dollars.

What this winds up meaning is that at a higher price (price = valuation), the money put in by investors (let’s say $5 million) buys a lower percentage of the company. If you say that the company’s valuation walking in the door is $10 million (the “pre-money valuation“), the $5 million put in by the investors buys one third of the company (because the company will then have the $10 million of presumed value plus $5 million of cash in the bank, resulting in a $15 million “post-money valuation“). If, on the other hand, you say that the pre-money valuation is $20 million, the new money will only buy 20% ($5M out of $25M) of the company rather than 33%.

Just to do the simple arithmetic, if you assume this is the first money into the company, the outcome of these two scenarios looks quite different for the founders. In the first scenario, the founders own 66% of a $15 million company. They are worth $10 million on paper. In the second scenario, they own 80% of a $25M company and are worth $20 million on paper. In both cases their company ends the financing with $5 million of cash to grow the business.

So you are now asking why I’m suggesting that you might not want to raise the round at the highest valuation you can possibly get. And a good many of you are rolling your eyes at the obvious self-interest we as investors have in this negotiation (which is undoubtedly true – we are interested, but bear with me).

There are at least two very good reasons why you might not want to go for the highest possible valuation.

1. You are probably going to have to raise money again.

2. The valuation you get today impacts your exit possibilities.

The first is critical, and many first-time entrepreneurs miss this. When you raise money, you should have it in the back of your mind that you will probably be raising money a second time. While most companies (especially web companies) come in with the idea that the raise being done today gets them to cash-flow positive, realistically it often doesn’t turn out that way. We understand this and it’s ok that you will need more money, but you should understand this too. When you go out to raise that next round, recognize that your current investors are going to want a step-up in valuation and so will you. Secondly, new investors are going to want to see momentum in the business.

The critical point is this: If you raise money at too high a valuation, you are going to have a very hard time raising money the next time around. Your current investors are going to balk at taking a flat or marked-down valuation, and they will almost assuredly have anti-dilution protection that will keep them whole while diluting YOU, the founder (and your team). New investors are going to be wary of investing in a company that has to be marked down from its previous price. Either way, your overpriced first round is going to be a huge headache when you go back out to raise money, and new investors are likely going to re-price the company anyway.

The second reason is equally important. Simply put, if you raise money at a high valuation it will be very difficult to sell your company for anything less than a significant multiple of that valuation. When your investors purchase a portion of your company, they do so with the hope and expectation that they will earn a multiple on their money when you eventually sell the business or take it public. Put in more concrete terms, if you raise money at a given valuation, you should assume that in the near term and in a success situation, you will be expected to get more than 4x that valuation in an exit.

So when you go to raise money, think about both of these factors. Think about what proof points you will likely reach when you go out to raise more money, and be wary of a valuation that puts you in a difficult position when that time comes. And try to be mindful of what constitutes a successful outcome for you. If you raise money at $50M post-money valuation, you are implicitly saying you can build a very large business and you are taking a good (but not huge) outcome off the table for yourself. Make sure this is a decision you make consciously.

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Isn’t this kind of like saying, “Don’t hoodwink/strong-arm your investors into paying too much for a stake in your company because it will come back to haunt you later?”. While I agree with that in principle, from what I hear VCs are typically pretty good negotiators. I wouldn’t expect too many entrepreneurs to be kicking themselves for giving their VCs such a raw deal in the first round that it made future rounds really difficult. Does this happen a lot?

Don’t you think down rounds are more likely the result of things just not going as well as everyone (VCs and entrepreneurs ) had hoped?

To Dave – I don’t think founders need to worry so much about giving VCs a “raw deal”. The larger point is that there are potential consequences to the entrepreneur him or herself for an excessive valuation. The negotiation with investors is just that – a negotiation. The point of the post, though, is to caution founders about the possible winner’s curse of a very high valuation, and to note that even if you can get it, it might not be the best idea.

I admit I had “my eyes rolling”… but the 2 points make sense. While I doubt that entrepreneurs rarely give VCs a raw deal, it’s important for entrepreneurs to keep in mind this message when start-up do the seed round with friends, family and business angels.

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